Sample Business Valuation Methods

Capitalized Earning Approach – A common method of valuing a business is called the Capitalization of Earnings (or Capitalized Earnings) method. Capitalization refers to the return on investment that is expected by an investor. There are many variations in how this method is applied. However, the basic logic is the same. To demonstrate the capitalization method of valuation, let’s look at a mythical and highly oversimplified business. Pretend the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $10,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $10,000 per year ($10,100-$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back. A buyer would look at this “minimum risk” business earning $10,000 and compare it to other ways of investing his or her money to earn $10,000 per year. Let’s assume a near no risk investment like a savings account or government treasury bills currently pays about 8% a year. At the 8% rate, for someone to earn the same $10,000 per year that the magic PO box earns, an investment of $125,000 (125,000*8%= $10,000) would be required. Therefore, the PO box value is in the area of $125,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill. Now the real world of business has no magic PO boxes and no “no risk” situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. However, as we’ll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning. Finally, it is important to point out that the above example does not include a fair salary for the new business owner. If the owner must devote time working to realize a profit, he or she must, in theory, be paid a fair value for that work. The owner’s fair and reasonable salary must be separated from the return on investment computations. For example, if the magic PO box produced $30,000 per year but required a manager with a fair market salary of $20,000, the income for valuation purposes is $10,000, not $30,000. The fair market value for salary is the important number to use, not the actual salary to the current owner.

Excess Earning Method – This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let’s suppose Mr. Owner runs a business that manufactures novelty products. His company has Tangible Assets of $300,000. Further let’s suppose that Mr. Owner pays himself a very reasonable market value salary– the same amount that he would have to pay a competent manager to do his job. After paying the salary Mr. Owner’s business has earnings of $120,000. The financially rational reason for owning business assets is to produce a financial return. Let’s say that a reasonable return on Mr. Owner’s Tangible Assets is 15% per year. A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions. For example, Mr. Owner or his advisors may have looked up industry standards for novelty manufacturing shops and found that the current average return on assets was 14%. (An alternative approach to finding an industry appropriate return on asset figure is to use a rate 2 to 3 points above the current bank rate for a small business loan, or about 5 points above the current prime rate).

So $45,000 of Mr. Owner’s profits are derived from the tangible assets of the business ($300,000 x 15%= $45,000) The other $75,000 ($120,000-$45,000=$75,000) in earnings are the excess earnings). This $75,000 excess earning number is typically multiplied by a factor of 2 to 5 based on such factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical number is 3 for a solid, profitable company. That is, a good business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook. Let’s suppose that Mr. Owner’s business is a bit better than average in these factors and assign a multiplier of 3.6. Therefore, the value of this business can be determined as follows:

The capitalization methods work for businesses that derive their income primarily from tangible assets such as a utility (such as gas or electric companies). In the case of most small businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use.

Cash Flow Method – Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization but also subtract from cash flow an estimated annual amount for equipment replacement. They will also adjust owner’s salary to a fair salary or at least an acceptable salary for the new owner. The adjusted cash flow number is used as a benchmark to measure the firm’s ability to service debt. If the adjusted cash flow is, for example, $100,000, and prevailing interest rates are 10%, and the buyer wants to amortize the loan over 5 years, the maximum a buyer is willing to pay for the firm would be $392,211. This is the amount that $100,000 per year would support over 5 years. Therefore, when using this method, the value of a company changes with interest rate conditions. It also changes with the terms a buyer can obtain on a business loan. From a buyer’s perspective this may make sense, but from a seller’s perspective it introduces a sort of arbitrariness into the process.

Tangible Assets(Balance Sheet) Method – In some instances, a business is worth no more than the value of its tangible assets. This would be the case for some (not all) businesses that are losing money or paying the owner(s) less in total than a fair market compensation. Selling such a business is often a matter of getting the best possible price for the equipment, inventory, and other assets of the business. It is generally best to approach other firms in the same business that would have direct use for such assets. Also, a company in the same business might be interested in taking over your facility. This would mean your leasehold improvements (modifications to space, etc.) would have value and the equipment would have value as “in place” plant and equipment. In place value is higher than the value on a piece by piece basis such as at a sale by auction.
Cost To Create Approach (Leap Frog Start-Up) Sometimes companies or individuals will purchase a company just to avoid the difficulties of starting from scratch. The buyer will calculate his or her start up needs in terms of dollars and time. Next he or she will look at your business and analyze what it has and what it may be missing relative to the buyer’s start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, copyrights, contracts, etc.). A reasonable premium of above the sum of projected start up costs may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming startup is likely to be, the higher the value would be based upon this method.

Rule of Thumb Methods – One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which we believe to be as adjuncts to other methods. One industry rule of thumb says an Internet Service Provider company is worth $75 to $125 per subscriber plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of one year’s gross income. The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 100 small weekly newspapers that were sold over a two year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year’s gross income. The rule of thumb is thus created. However, some newspapers may have sold for twice one year’s gross while other may have sold for half of one year’s gross. The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate.

Value of Specific Intangible Assets – This is an often overlooked approach to valuation. Yet in some cases it is the only appropriate approach that will result in a sale. The approach is based upon the buyer’s buying a wanted intangible asset versus creating it. Many times buying can be a cost efficient and time saving alternative. For example, we recently sold a temporary employment agency. This agency specialized in placing health care assistants (such as nurses aids) in hospitals and nursing homes. Because there is a shortage of these workers in the area where the selling company did business, placing workers was not difficult. However, finding qualified workers was very difficult. We approached firms in the same and related businesses. Through our research, we calculated that recruiting a qualified worker cost at least $200 for an agency. Therefore, we were able to obtain a price of $170.00 for each worker in the pool of available employees by showing a competitor that this would save them money. In fact, this not only saved $30.00 per worker, but it also cut down on recruiting time to recruit. The overhead of the selling company was not an issue because the buying company already had the system in place that the overhead expense was paying for (offices, computer system, phones, etc.). In fact, whether the seller was making or losing money was of little consequence to the buyer. The value to the buyer was the value of buying a qualified worker versus recruiting a worker through the more traditional method of advertising, interviewing, etc. A common application of this method is the acquisition of a customer base. Customers with a high likelihood of being retained are valuable in most industries. Examples of industries where companies are bought and sold based upon the value of the customer base include insurance agencies, advertising agencies, payroll services, and bookkeeping services. In practice the buyer will often ask for a credit for each customer that is not retained for a stated period of time. For example, a firm may offer $100 per customer, with a pro-rated credit for each customer lost during the twelve months following the closing of the sale. Pro-rating is based upon the time the customer is lost– if the customer is lost after 6 months, for example, half of the $100 would be returned to the seller.

Conclusion – There is no surefire way to value a company for buying and selling purposes. The true value is the perceived value to a buyer who is ready, willing, and able to buy it. However, there are a number of approaches to estimate value; some of those are discussed above. It is not unusual for a buyer to ask for the logic behind an asking price. Having a good answer to that question will enhance your chances of selling your firm for the desired price.